The consequences of federal intervention in the financial system

As Congress comes back from recess, the move towards increasing financial regulations will pick back up in earnest. From regulating hedge funds to widening the oversight roles of the Federal Reserve and Securities and Exchange Commission, we’re seeing a Washington power grab like never before. Treasury Secretary Tim Geithner has asked Congress to grant the government more authority, but before they do, lawmakers should take a look at history to see the consequences of past federal financial activism.

Before 1979, the Federal Reserve (Fed) used “interest rate targeting” as monetary policy to stimulate economic growth. But to manipulate interest rates the Fed would expand and contract the money supply in reaction to the market cycle. But because of the lag between this policy’s implementation and when it impacts the economy, the long-term ramifications were nearly impossible to predict. We now know that the unforeseen result of excessive growth in the money supply, combined with oil price shocks and price controls, ultimately resulted in 1970s “stagflation.”

To address this issue, then Fed Chairman Paul Volcker (now chairman of the President’s Economic Recovery Advisory Board), decided in October 1979 to annually increase the money supply at a fixed rate, essentially slowly increasing inflation in a predictable way. By slowly increasing the money supply annually and directly adjusting interest rates, lag effects become more stable. However, this policy of “inflation targeting” can result in wildly fluctuating interest rates-and that can have negative long-term consequences.

Bond prices move inversely to interest rates, and after Volcker’s monetary policy shift towards steady inflation in 1979, bond prices began fluctuate. Traditionally a conservative investment instrument, the destabilization of bond prices increased their potential value. This stability shift contributed to the emergence of junk bonds that, despite their high yield potential, carried a high risk of default and were partially to blame for the Savings and Loan Crisis in the 1980s.

But more important for our story today was the development of mortgage bonds-and ultimately the infamous mortgage-backed security.

Ironically, the whole mortgage-backed investment model almost never got off the ground. Lewis Ranieri, a trader at Salomon Brothers (now a part of Citigroup), is credited with first conceiving the idea in 1978. But Salomon Brothers almost canned Ranieri’s whole department because there didn’t seem to be a profitable future for mortgage trading.

Former Salomon broker Michael Lewis writes in his book Liar’s Poker, “The mortgage department wasn’t making money. The other mortgage units on Wall Street-Merrill Lynch, First Boston, Goldman Sachs-were stillborn. They closed almost before they had opened. The prevailing wisdom was that mortgages were not for Wall Street.”

That’s when the government stepped in.

A side effect of the Fed decision to increase the money supply was an uptick in interest rates after 1979. This negatively impacted mortgage lending at Savings and Loan banks (S&Ls). Under “Regulation Q” of the 1933 Glass-Steagall Act, the government, seeking to promote homeownership, exercised its power to place a ceiling on the interest rate S&Ls could charge a borrower for a mortgage. But this limited their ability to compete with alternative, unregulated funds for capital. The unregulated funds (such as money market funds) could offer a better rate of return for investors

The S&Ls had two options: make no further loans until interests rates went down, leaving them with no revenue, or sell off their loans at a loss and hopefully last long enough for rates to decline. As a result, many S&Ls without enough capital to wait for lower interest rates were forced to shut down.

In late 1981, seeing the error of their ways, Congress offered S&Ls a tax break. As a reward for their advocacy of homeownership, the banks could get up to 10 years of taxes per loan back, if they showed a loss on the sale of that loan. Essentially the government gave S&Ls an incentive to take a loss.

Selling off the mortgages was easy. All S&Ls had to do was call an investment bank and take whatever price they could get. Salomon Brothers and others snapped up the mortgages at rock bottom prices. Then investment banks began bundling these cheaply acquired mortgages into different investment vehicles, and sold them to investors looking for a quick dollar. Suddenly, mortgages were more profitable for Ranieri’s department. Mortgage-backed investments were saved, thanks to Uncle Sam.

The rest of the story is already widely known. The lesson has not quite set in though.

While banks share a hefty portion of the blame for our current financial crisis, it wasn’t capitalism that failed. Lew Ranieri wasn’t wrong for trying to develop a new mortgage bond investment vehicle. But when it was first introduced to the market it wasn’t very successful. The demand wasn’t there. Or at least it wasn’t there yet. It took government activity in the financial sector, through S&L rate ceilings and fancy tax incentives, to create a market for the evolution of mortgage-backed securities.

Mortgage bonds might have died at the hands of the free market long ago. But the government, as it does more often than not, felt it could help the free market do better. It was noble for the government to promote the “American Dream” and under Presidents Bill Clinton and George W. Bush, Fannie Mae and Freddie Mac handed out billions in subprime loans that did help many get affordable housing. However, those risky loans haven’t lasted, and the long-term effects have only hurt the economy and American people.

The Obama administration’s push for increased regulatory power appears to be well-intentioned–to prevent another downturn like this. But history has shown time and again that government is unable to predict the negative and long-term consequences of its actions. Allowing the market to work freely is the best way to help people across the economic spectrum live more prosperously.

Anthony Randazzo is a policy analyst at Reason Foundation. J. Dustin Pope is a Business Development Associate with Hynes Associates.

Anthony Randazzo is director of economic research for Reason Foundation, a nonprofit think tank advancing free minds and free markets. His research portfolio is regularly evolving, and he maintains a wide interest in economic policy at both a domestic and international level.